Summary of FSAP Experience25

Stress tests have been performed for every country participating in the FSAP. The tests are designed to provide a quantitative measure of the vulnerability of the financial system to different shocks and to complement the insights gathered from other components of the assessment. This analysis includes elements of the legal, institutional, regulatory, and supervisory framework; observance of key financial sector standards and codes; analysis of the financial system structure and key vulnerabilities; and empirical analysis of financial soundness indicators.

Data availability is a key factor in determining the approach and sophistication of stress tests performed as part of the FSAP. Most analyses are performed on a bank-by-bank (bottom-up) basis, which is based on single factor and scenario approaches. Contagion risks and second-round effects have typically not been addressed in many FSAPs, although some have incorporated elements of interbank contagion into the exercise. The involvement of the authorities has varied according to their expertise and ability or willingness to provide data, with some country authorities precluded from providing data on individual institutions by bank secrecy laws or conventions. For countries that have published the summary assessment of the FSAP mission, most have included a summary of the stress-testing results.26

The overall approach and implementation of stress tests as part of the FSAP has evolved over time. Some recent trends include the following:

As familiarity and use of the techniques have spread, country authorities and individual financial institutions now play a greater role in the design and imple­mentation of stress tests. Increased reliance is being placed on using the internal models of banks to evaluate the effect of shocks, including their off-balance-sheet exposures.

The use of macrosimulation models to calibrate a macroscenario has increased, and several recent FSAPs have included interbank contagion calculations.

Coverage of nonbank financial institutions has increased, with many insurance companies now being included in many cases as part of the analysis.

Many country authorities are now implementing their own stress-testings programs as part of their macroprudential surveillance, partly as a result of FSAP-related work.

Notes

1. This section draws substantially on Jones, Hilbers, and Slack (2004). Useful overviews and surveys of the relevant literature are also contained in Blaschke et al. (2001), Cihak (2004a), and Sorge (2004).

2. System-focused stress tests can also take the form of sensitivity tests, in which only a single risk factor is shocked. In this paper, we focused on scenarios, but sensitivity tests can be considered in the same framework as a one-dimensional scenario.

3. For an interesting example of the use of macroeconomic modeling to assess the poten­tial effect of specific vulnerabilities, see Gereben, Woolford, and Black (2003) for a scenario analysis for New Zealand.

4. See Hoggarth and Whitley (2003) for further details, and a discussion of how the approach was used for the U. K. FSAP.

5. Many large banks have value at risk frameworks in place for internal monitoring of risk positions [see Jorion (2001) for a survey of Value at Risk methods]. For an international review of stress testing practices in large banks, see Committee on the Global Financial System (2000). Banks that follow the Basel Committee’s internal ratings-based approach are required by their supervisors to have a comprehensive stress-testing program in place (Basel Committee on Banking Supervision 2003). With the implementation of Basel II, stress tests are set to become more commonplace in banks.

6. See section D.3 for a discussion of stress testing of insurance companies.

7. In some cases, it may be useful to calibrate the size of shocks to cause one or more of the institutions involved to breach their minimum capital requirement so they can determine the magnitude of shocks necessary to cause such a “failure.” However, as the size of the shocks increases, the accuracy of most estimation methods decreases, thereby increasing the potential margin of error.

8. For more details, see Basel Committee on Banking Supervision (1998).

9. This relation is valid if the net open position is long or short, that is, F ф 0.

10. More realistically, we could deduct the effect of the shock first from profits and only then from capital. However, it would make the notation more complex without pro­viding many additional insights.

11. Empirically, AARW/AC could be estimated by a regression. In practice, FSAP stress tests have usually been based on simplifying assumptions, such as AARW /AC =1 or 0.

12. So far, however, most stress tests in FSAP missions have not incorporated such non­linear effects. The Compilation Guide on Financial Soundness Indicators (IMF 2004) encourages the identification of the component elements of the net open position, including options in bought and sold positions.

13. Given the practical difficulties involved in obtaining empirical data on open positions in the household sector, for simplicity we refer here only to the corporate sector, even though the theoretical analysis would be essentially the same even if we included the household sector.

14. Chapter 3 shows that for a panel of 47 countries, a 10-percentage point rise in the corporate leverage was associated with a 1.1-percentage point rise in NPL/TL after a 1 year lag.

15. Duration is defined as the weighted average term-to-maturity of an asset’s (liability’s) cash flow, the weights being the present value of each future cash flow as a percent­age of the asset’s (liability’s) full price. See the Compilation Guide on FSIs (IMF 2004, paragraph 3.52) for a formula that could be used to calculate duration.

16. The effects can also be expressed in terms of banks’ profitability, which may be use­ful when branches of foreign banks, which typically do not have own capital, play an important role in the local economy. Bierwag (1987) derived the effect on profits in the case of a single bank.

17. The actual FSI may be somewhat different, because it refers to regulatory capital rather than the difference of market values of assets and liabilities.

18. Only about 20 percent of FSAPs conducted a duration-based stress test (see IMF and World Bank 2003). The rest typically used simplified methods such as maturity gaps or earnings at risk.

19. The Compilation Guide on Financial Soundness Indicators (IMF 2004) includes a table showing how such simplified measure can be calculated. An even simpler approach would be based on the average maturity of assets and liabilities.

20. For instance, in the case of Hong Kong SAR, it has been estimated that an increase in nominal interest rates by 1 percentage point leads to a rise in the classified loan ratio by 0.2 percentage points with a lag of two quarters (Shu 2002).

21. Barnhill, Papanagiotou, and Schumacher (2000) provide an example of such simula­tions for South African banks.

22. Although the increasingly widespread use of derivatives may permit a more rapid adjustment in exposures.

23. See Cihak (2004a, b) for further details. Upper and Worms (2002), Furfine (1999), Degryse and Nguyen (2004), and Gropp and Vesala (2004) also examine interbank contagion.

24. The simplest way to implement this is to assume that a bank fails if its capital becomes negative as a result of the shock. A more complex calculation could be based on a mapping from capital adequacy to the probability of failure, if such mapping could be estimated based on past data.

25. This section is based on International Monetary Fund and World Bank (2003) and International Monetary Fund and World Bank (2005).

26. See http://www. imf. org/external/np/fsap/fsap. asp#cp for copies of published reports.

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